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CHAPTER 4

Interest Rates

Practice Questions

Problem 4.8.
The cash prices of six-month and one-year Treasury bills are 94.0 and 89.0. A 1.5-year bond
that will pay coupons of $4 every six months currently sells for $94.84. A two-year bond that
will pay coupons of $5 every six months currently sells for $97.12. Calculate the six-month,
one-year, 1.5-year, and two-year zero rates.

The 6-month Treasury bill provides a return of 6 / 94 = 6.383% in six months. This is
2 �6.383 = 12.766% per annum with semiannual compounding or 2 ln(1.06383) = 12.38%
per annum with continuous compounding. The 12-month rate is 11 / 89 = 12.360% with
annual compounding or ln(1.1236) = 11.65% with continuous compounding.
For the 1 12 year bond we must have
4e -0.1238�0.5 + 4e -0.1165�1 + 104e-1.5 R = 94.84
where R is the 1 12 year zero rate. It follows that
3.76 + 3.56 + 104e -1.5 R = 94.84
e -1.5 R = 0.8415
R = 0.115
or 11.5%. For the 2-year bond we must have
5e -0.1238�0.5 + 5e -0.1165�1 + 5e -0.115�1.5 + 105e -2 R = 97.12
where R is the 2-year zero rate. It follows that
e -2 R = 0.7977
R = 0.113
or 11.3%.

Problem 4.9.
What rate of interest with continuous compounding is equivalent to 15% per annum with
monthly compounding?

The rate of interest is R where:


12
� 0.15 �
eR = �
1+ �
� 12 �
i.e.,
� 0.15 �
R = 12 ln �
1+ �
� 12 �

= 0.1491
The rate of interest is therefore 14.91% per annum.
Problem 4.10.
A deposit account pays 12% per annum with continuous compounding, but interest is
actually paid quarterly. How much interest will be paid each quarter on a $10,000 deposit?

The equivalent rate of interest with quarterly compounding is R where


4
� R�
e0.12 = �1+ �
� 4�
or
R = 4(e0.03 - 1) = 0.1218

The amount of interest paid each quarter is therefore:


0.1218
10, 000 � = 304.55
4
or $304.55.

Problem 4.11.
Suppose that 6-month, 12-month, 18-month, 24-month, and 30-month zero rates are 4%,
4.2%, 4.4%, 4.6%, and 4.8% per annum with continuous compounding respectively. Estimate
the cash price of a bond with a face value of 100 that will mature in 30 months and pays a
coupon of 4% per annum semiannually.

The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The cash price is
2e -0.04�0.5 + 2e -0.042�1.0 + 2e -0.044�1.5 + 2e-0.046�2 + 102e-0.048�2.5 = 98.04

Problem 4.12.
A three-year bond provides a coupon of 8% semiannually and has a cash price of 104. What
is the bond’s yield?

The bond pays $4 in 6, 12, 18, 24, and 30 months, and $104 in 36 months. The bond yield is
the value of y that solves
4e-0.5 y + 4e-1.0 y + 4e-1.5 y + 4e-2.0 y + 4e -2.5 y + 104e-3.0 y = 104
Using the Goal Seek or Solver tool in Excel y = 0.06407 or 6.407%.

Problem 4.13.
Suppose that the 6-month, 12-month, 18-month, and 24-month zero rates are 5%, 6%, 6.5%,
and 7% respectively. What is the two-year par yield?

Using the notation in the text, m = 2 , d = e-0.07�2 = 0.8694 . Also


A = e-0.05�0.5 + e-0.06�1.0 + e -0.065�1.5 + e-0.07�2.0 = 3.6935
The formula in the text gives the par yield as
(100 - 100  0.8694)  2
= 7.0741
3.6935
To verify that this is correct we calculate the value of a bond that pays a coupon of 7.0741%
per year (that is 3.5370 every six months). The value is
3.537e -0.050.5 + 3.537e -0.061.0 + 3.537e -0.0651.5 + 103.537e -0.072.0 = 100

verifying that 7.0741% is the par yield.


Problem 4.14.
Suppose that risk-free zero interest rates with continuous compounding are as follows:

Maturity( years) Rate (% per annum)


1 2.0
2 3.0
3 3.7
4 4.2
5 4.5

Calculate forward interest rates for the second, third, fourth, and fifth years.

The forward rates with continuous compounding are as follows: to


Year 2: 4.0%
Year 3: 5.1%
Year 4: 5.7%
Year 5: 5.7%

Problem 4.15.
Use the risk-free rates in Problem 4.14 to value an FRA where you will pay 5% for the third
year and receive LIBOR on $1 million. The forward LIBOR rate (annually compounded) for
the third year is 5.5%.

The 3-year risk-free interest rate is 3.7% with continuous compounding. From equation
(4.10), the value of the FRA is therefore
[1, 000, 000 �(0.055 - 0.05) �1]e -0.037�3 = 4, 474.69
or $4,474.69.

Problem 4.16.
A 10-year, 8% Treasury coupon bond currently sells for $90. A 10-year, 4% coupon Treasury
bond currently sells for $80. What is the 10-year zero rate? (Hint: Consider taking a long
position in two of the 4% coupon bonds and a short position in one of the 8% coupon bonds.)

Taking a long position in two of the 4% coupon bonds and a short position in one of the 8%
coupon bonds leads to the following cash flows
Year 0: 90 − 2×80 = −70
Year 10: 200 – 100 = 100
because the coupons cancel out. $100 in 10 years time is equivalent to $70 today. The 10-year
rate, R, (continuously compounded) is therefore given by
100 = 70e10 R
The rate is
1 100
ln = 0.0357
10 70
or 3.57% per annum.

Problem 4.17.
Explain carefully why liquidity preference theory is consistent with the observation that the
term structure of interest rates tends to be upward sloping more often than it is downward
sloping.
If long-term rates were simply a reflection of expected future short-term rates, we would
expect the term structure to be downward sloping as often as it is upward sloping. (This is
based on the assumption that half of the time investors expect rates to increase and half of the
time investors expect rates to decrease). Liquidity preference theory argues that long term
rates are high relative to expected future short-term rates. This means that the term structure
should be upward sloping more often than it is downward sloping.

Problem 4.18.
“When the zero curve is upward sloping, the zero rate for a particular maturity is greater
than the par yield for that maturity. When the zero curve is downward sloping the reverse is
true.” Explain why this is so.

The par yield is the yield on a coupon-bearing bond. The zero rate is the yield on a zero-
coupon bond. When the yield curve is upward sloping, the yield on an N-year coupon-bearing
bond is less than the yield on an N-year zero-coupon bond. This is because the coupons are
discounted at a lower rate than the N-year rate and drag the yield down below this rate.
Similarly, when the yield curve is downward sloping, the yield on an N-year coupon bearing
bond is higher than the yield on an N-year zero-coupon bond.

Problem 4.19.
Why are U.S. Treasury rates significantly lower than other rates that are close to risk free?

Two reasons (see Section 4.3) are:


1. The amount of capital a bank is required to hold to support an investment in Treasury bills
and bonds is zero whereas capital is required to support a similar investment in other
very-low-risk instruments.
2. In the United States, Treasury instruments are given a favorable tax treatment compared
with most other fixed-income investments because they are not taxed at the state level.

Problem 4.20.
Why does a loan in the repo market involve very little credit risk?

A repo is a contract where an investment dealer who owns securities agrees to sell them to
another company now and buy them back later at a slightly higher price. The other company
is providing a loan to the investment dealer. This loan involves very little credit risk. If the
borrower does not honor the agreement, the lending company simply keeps the securities. If
the lending company does not keep to its side of the agreement, the original owner of the
securities keeps the cash.

Problem 4.21.
Explain why an FRA is equivalent to the exchange of a floating rate of interest for a fixed
rate of interest?

A FRA is an agreement that a certain specified interest rate, RK , will apply to a certain
principal, L, for a certain specified future time period. Suppose that the rate observed in the
market for the future time period at the beginning of the time period proves to be RM . If the
FRA is an agreement that RK will apply when the principal is invested, the holder of the FRA
can borrow the principal at RM and then invest it at RK . The net cash flow at the end of the
period is then an inflow of RK L and an outflow of RM L . If the FRA is an agreement that RK
will apply when the principal is borrowed, the holder of the FRA can invest the borrowed
principal at RM . The net cash flow at the end of the period is then an inflow of RM L and an
outflow of RK L . In either case, we see that the FRA involves the exchange of a fixed rate of
interest on the principal of L for a floating rate of interest on the principal.

Problem 4.22.
Explain how a repo agreement works and why it involves very little risk for the lender.

The borrower transfers to the lender ownership of securities which have a value
approximately equal to the amount borrowed and agrees to buy them back for the amount
borrowed plus accrued interest at the end of the life of the loan. If the borrower defaults, the
lender keeps the securities. Note that the securities should not have a value significantly more
or less than the amount borrowed. Otherwise the risk of a loss if the borrower or the lender
does not live up to its obligations may be unacceptable.

Further Questions

Problem 4.23
When compounded annually an interest rate is 11%. What is the rate when expressed with (a)
semiannual compounding, (b) quarterly compounding, (c) monthly compounding, (d) weekly
compounding, and (e) daily compounding.

We must solve 1.11=(1+R/n)n where R is the required rate and the number of times per year
the rate is compounded. The answers are a) 10.71%, b) 10.57%, c) 10.48%, d) 10.45%, e)
10.44%

Problem 4.24
The following table gives Treasury zero rates and cash flows on a Treasury bond:

Maturity (years Zero rate Coupon payment Principal


0.5 2.0% $20
1.0 2.3% $20
1.5 2.7% $20
2.0 3.2% $20 $1000

Zero rates are continuously compounded


(a) What is the bond’s theoretical price?
(b) What is the bond’s yield?

The bond’s theoretical price is


20×e-0.02×0.5+20×e-0.023×1+20×e-0.027×1.5+1020×e-0.032×2 = 1015.32
The bond’s yield assuming that it sells for its theoretical price is obtained by solving
20×e-y×0.5+20×e-y×1+20×e-y×1.5+1020×e-y×2 = 1015.32
It is 3.18%.

Problem 4.25 (Excel file)


A five-year bond provides a coupon of 5% per annum payable semiannually. Its price is 104.
What is the bond's yield? You may find Excel's Solver useful.

The answer (with continuous compounding) is 4.07%

Problem 4.26 (Excel file)


Suppose that 3-month, 6-month, 12-month, 2-year, and 3-year OIS rates are 2.0%, 2.5%,
3.2%, 4.5%, and 5%, respectively. The 3-month, 6-month and 12-month OISs involve a single
exchange at maturity; the 2-year and 3-year OISs involve quarterly exchanges. The
compounding frequencies used for expressing the rates correspond to the frequency of
exchanges. Calculate the OIS zero rates using continuous compounding. Interpolate linearly
between continuously compounded rates to determine rates between 6 months and 12
months, between 12 months and 2 years, and between 2 years and 3 years. You may find
Excel’s Solver useful.

The calculations are indicated on the Excel file. The 3-month, 6-month, 12-month, 2-year and
3-year zero rates are 1.9950%, 2.4845%, 3.1499%, 4.5153%, and 5.0264%, respectively.

Problem 4.27
An interest rate is quoted as 5% per annum with semiannual compounding. What is the
equivalent rate with (a) annual compounding, (b) monthly compounding, and (c) continuous
compounding.

a) With annual compounding the rate is 1.0252 - 1 = 0.050625 or 5.0625%


b) With monthly compounding the rate is 12 �(1.0251/ 6 - 1) = 0.04949 or 4.949%.
c) With continuous compounding the rate is 2 �ln1.025 = 0.04939 or 4.939%.

Problem 4.28.
The 6-month, 12-month. 18-month,and 24-month risk-free zero rates are 4%, 4.5%, 4.75%,
and 5% with semiannual compounding.
a) What are the rates with continuous compounding?
b) What is the forward rate for the six-month period beginning in 18 months
c) What is two-year par yield

a) With continuous compounding the 6-month rate is 2 ln1.02 = 0.039605 or 3.961%.


The 12-month rate is 2ln1.0225 = 0.044501 or 4.4501%. The 18-month rate is
2ln1.02375 = 0.046945 or 4.6945%. The 24-month rate is 2 ln1.025 = 0.049385 or
4.9385%.
b) The forward rate (expressed with continuous compounding) is from equation (4.5)
4.9385 �2 - 4.6945 �1.5
0.5
or 5.6707%. When expressed with semiannual compounding this is
2(e0.056707�0.5 - 1) = 0.057518 or 5.7518%.
c) The value, A of an annuity paying off $1 every six months is
e -0.039605�0.5 + e-0.044501�1 + e -0.046945�1.5 + e -0.049385�2 = 3.7748
The present value of $1 received in two years, d , is e -0.049385�2 = 0.90595 . From the
formula in Section 4.6 the par yield is
(100 - 100 �0.90595) �2
= 4.983
3.7748
or 4.983%.

Problem 4.29.
Suppose that the risk-free rates are as in Problem 4.28. What is the value of an FRA where
the holder pays LIBOR and receives 7% (semiannually compounded) for a six-month period
beginning in 18 months. The current forward LIBOR rate for the period is 6% (semiannually
compounded).

The value of the FRA is


0.5 �(0.07 - 0.06) �$10, 000, 000 /1.0254 = $45, 297.53

Problem 4.30.
The following table gives the prices of Treasury bonds

Bond Principal ($) Time to Maturity (yrs) Annual Coupon ($)* Bond Price ($)
100 0.5 0.0 98
100 1.0 0.0 95
100 1.5 6.2 101
100 2.0 8.0 104

*Half the stated coupon is paid every six months

a) Calculate zero rates for maturities of 6 months, 12 months, 18 months, and 24


months.
b) What are the forward rates for the periods: 6 months to 12 months, 12 months to 18
months, 18 months to 24 months?
c) What are the 6-month, 12-month, 18-month, and 24-month par yields for bonds that
provide semiannual coupon payments?
d) Estimate the price and yield of a two-year bond providing a semiannual coupon of
7% per annum.

a) The zero rate for a maturity of six months, expressed with continuous compounding is
2 ln(1 + 2 / 98) = 4.0405% . The zero rate for a maturity of one year, expressed with
continuous compounding is ln(1 + 5 / 95) = 5.1293 . The 1.5-year rate is R where
3.1e -0.040405�0.5 + 3.1e-0.051293�1 + 103.1e- R�1.5 = 101
The solution to this equation is R = 0.054429 . The 2.0-year rate is R where
4e -0.040405�0.5 + 4e -0.051293�1 + 4e -0.054429�1.5 + 104e - R�2 = 104
The solution to this equation is R = 0.058085 . These results are shown in the table
below

Maturity (yrs) Zero Rate (%) Forward Rate Par Yield


(%)
0.5 4.0405 4.0405 4.0816
1.0 5.1293 6.2181 5.1813
1.5 5.4429 6.0700 5.4986
2.0 5.8085 6.9054 5.8620
b) The continuously compounded forward rates calculated using equation (4.5) are
shown in the third column of the table

c) The par yield can be calculated from the formula in Section 4.6. It is shown in the
fourth column of the table.

d) The price of the bond is


3.5e-0.040405�0.5 + 3.5e-0.051293�1 + 3.5e-0.054429�1.5 + 103.5e-0.058085�2 = 102.13
The yield on the bond, y satisfies
3.5e - y�0.5 + 3.5e- y�1.0 + 3.5e- y�1.5 + 103.5e- y�2.0 = 102.13
The solution to this equation is y = 0.057723 . The bond yield is therefore 5.7723%.